climate change risk classification methodology
by Tamara Close climate change as an unpriced systemic risk During the 2008/09 Financial Crisis, some market participants blamed Fair Value Accounting and Fair Market Valuations (FMV) for a worsening of the financial crisis, since assets and loans that were still performing were required to be marked-to-market to what were then extremely low values, sometimes even to a zero value. This caused, in some cases, extreme decreases in NAVs and even caused some financial firms to become insolvent. Opponents of the fair value approach argued that the market was pricing in a risk that had already happened and was not likely to reoccur. Today we find ourselves in the opposite situation with a risk – climate change - that is known and will occur and yet it is not being priced into the market. Climate change is increasingly being viewed as a systemic risk, and the valuation of climate change risks (both physical and transition risks) represents a complex and multi-dimensional process for which there is currently no agreed-upon industry standard. Due to the inherent complexities of climate change risk, many investors are not factoring these risks into their investment valuations, or they are doing so at a broader sector or industry level, leaving investment / company level climate change risk as a largely unknown, unpriced, and yet very material risk in their portfolios. If there was a sudden repricing of climate change risk, we could see the same impact that we witnessed during the financial crisis.
climate change risk assessment classification methodology During the 2008/09 financial crisis, the valuation of complex OTC derivatives became increasingly unclear due to their dependence on certain underlying assumptions that no longer held as markets became dislocated. The FAS 157 classification methodology was developed to give investors and regulators a clearer view into the amount of complex OTC derivatives (classified as Level 3) in an investment portfolio. This required asset managers and asset owners to re-classify their financial assets into 3 risk levels. Investment firms were not required to change their valuation methodologies, but rather were required to classify their assets based on the valuation methodologies and inherent / perceived liquidity.
Intelligent Risk - April 2022
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